Only the versatile need apply

Legal and General Investment Management (LGIM) has some £300bn in assets under management invested globally. Almost half of this is invested in equities. Mary McCave, LGIM’s senior equity dealer, discusses how LGIM’s trading desk stays on top of the trade.

How is the trading process at Legal and General Investment
Management structured?

Our trading desk is based in London, and is responsible for
handling global trading requirements for both active and passive
funds. The desk consists of five people including myself, and we
handle all cash equity and equity derivatives trading. The
latter, which has traditionally been used for cashflow purposes
to synthesise cash, represents a growing part of our activity,
although not as yet a major part of our day-to-day volume.

Is the desk manned on a twenty-four hour basis?

Not currently - it is manned from 7 a.m. until 7 p.m. each day on
a shift basis. Having said that, if needs be, traders will come
in earlier or stay later, depending on the business requirements.
Because we have a relatively small trading team, everyone has to
be extremely versatile - while we all have certain specialist
areas, everybody has to be able to cover all markets and sectors
to allow for shift rotations and holidays etc.

How does the desk interact with Legal and General Investment
Management's portfolio managers?

Naturally we view our portfolio managers as our customers, and
are keen to interact with them as much as possible. The trading
desk is on the same floor as the fund managers; we have the
active managers on one side of us and the passive on the other,
which means we are ideally placed to stay in contact with them
during the day. Orders are sent through to the dealing desk on
our internal order management system (OMS). Whenever we receive
an order we will always make sure we speak to the fund manager -
we don't just take it at face value. We need to find out what
their objectives are and if they have any specific requirements.
We will then discuss our proposed execution strategy with them,
and estimate the cost of implementing the trade. We really value
that face to face interaction; it minimises the risk of important
details being lost in transit.

Managers tend to vary quite a bit in how they operate. Some opt
to give a lot of detailed guidance, while others prefer just to
outline their broad objectives and leave us to get on with it.
The managers take an interest in the trading process; I recently
did a presentation to some of them on how electronic trading is
evolving post-MiFID in terms of things such as smart order
routing, which attracted a lot of interest and questions.

"…we have already seen a huge migration of skills across
to the buyside that were previously long-established on the
sellside."

How is your trading technology structured?

We have our own internally developed OMS, which hooks into a lot
of other Legal and General Investment Management departments
internally and is primarily used for recording trades and
providing an audit trail. However, in view of the way the market
has changed in recent years, we felt we also needed a platform
from which we could easily access various execution algorithms
that we use and could also use to send orders via FIX. To that
end we have recently implemented Portware as our execution
management system, sitting on top of our proprietary OMS. One of
the most demanding parts of the project was developing the
interface between Portware and our OMS, but the effort was
certainly worthwhile. It gives us greater flexibility as regards
integrating new trading tools quickly, as well as being able to
further leverage the business integration and other benefits of
our order management system.

Have you considered using Portware to create your own execution
algorithms?

We aren't quite at that stage at present, but I certainly
wouldn't rule it out given the extent to which the industry is
changing. What we have been able to do is approach several
algorithm providers with a view to customising some of the
existing strategies to better suit our needs. In general, we have
already seen a huge migration of skills across to the buyside
that were previously long-established on the sellside. Given the
likely continuation of that trend, it is certainly conceivable
that it could become normal practice for the buyside to write
their own execution algorithms.

What was the motivation behind the implementation?

There were a number factors involved. In recent years, markets
have changed in many ways, not only in terms of regulation and
structure, but also in terms of participants' mentality and
capabilities. They continue to evolve at a considerable pace, and
with that in mind, having the type of technology that Portware
affords is no longer a luxury, it's an absolute necessity. With
new venues coming on-stream regularly, we were looking for a
system that would enable us to access multiple destinations and
liquidity pools quickly and easily. The world is changing, and
smart order routing is key - Portware allows us a greater degree
of flexibility in terms of managing our order flow to maintain
our competitive edge.

Another major factor was the desire to reduce the possibility of
information leakage. Because of the sheer size of our funds,
minimising this is hugely important for us, so the possibility of
achieving anonymity through technology is very attractive. In
addition, the Portware implementation would confer other benefits
such as greater control of order flow and cost savings.

Do you use a broad range of brokers?

That varies according to market. In the UK, the size of our
passive funds means that we typically manage in the region of 5%
of every FTSE All Share stock. Therefore, we are obviously a
major participant in that market, and consequently use a very
broad range of brokers - all the way from bulge bracket down to
small niche brokers, depending upon the type of trade we are
doing. In other regions, where we may be doing more passive
program trading, we use a smaller selection of brokers. Whatever
the situation, we are keen to identify specialists in all areas.

Would you say you take primarily a
quantitative or qualitative approach to measuring broker
performance?

I would certainly say that both approaches are essential for us,
although I feel it is very important not to look at either one in
isolation. I believe some desks use transaction cost analysis in
a purely quantitative manner to give their brokers a hard time
over execution costs, but I feel that is inappropriate for many
of our trades, particularly in live markets. When we are trading
in live markets, even if we use a broker for execution, we retain
a very high level of control over the process. We therefore tend
to look at things in a more qualitative manner and score brokers
in terms of factors such as capital commitment and information
flow. One important area for us is backup coverage; as sellside
sales trading desks have shrunk, you sometimes notice a
deterioration in the service if your primary contact is away from
the desk.

We maintain an internal scoring system where everyone on the
trading desk votes on each broker we use. Since we unbundled for
our Active funds, it is far easier to do this in a meaningful
manner from the desk's perspective, as we now have no need to
involve the fund managers or include factors such as research
quality. For live markets, although it is useful to record a
broker's ranking, the nature of the business means that we seek
liquidity wherever we can. Where the scoring system is extremely
useful is in markets where we are not trading in real-time, such
as Asia and Japan; if the dealer who specialises in a particular
area is off the desk and an order for their particular specialism
comes in then we can refer to a matrix that tells us which broker
is rated most highly for that particular category of trade.

Do you use multiple algorithm providers?

Yes, as I mentioned, the Portware implementation has made it
easier for us to plug in new algorithms, and we are taking
advantage of that to explore quite a wide variety of them. It is
healthy to interchange them, and, as you move away from the more
traditional strategies that have arguably become commoditised, to
try out newer, more sophisticated tactics. Although quite a few
firms have started promoting direct market access for equity
derivatives to us, our focus is still primarily on equity
algorithms at present.

Is there is a wide variation in the quality of tools and service
you receive from the sellside?

I think there is quite a variation and, therefore, we are
selective in our choice of brokers. We are keen to establish a
good working relationship with our counterparties, recognising
the two-way nature of the business. In our experience, we obtain
a much better service from our brokers by engaging with them on a
regular basis to ensure our mutual objectives are achieved.

What about the quality of education you receive from brokers on
their algorithms?

The algo providers who have been around for the longest already
have this down to a fine art and are very proactive in offering
to visit and ensuring that we are clear on how to achieve the
best possible results from the tools. Recently I've noticed that
some of the newer players have also started to pick up on the
importance of training, so the overall standard of training is
definitely improving.

Is there a strong feedback loop between the Legal and General
Investment Management trading desk and algorithm providers?

Yes, as our comfort level with using algorithms has increased, so
has our ability to provide performance feedback and a couple of
our major providers are very keen to solicit this. As I
mentioned, we have also been offered customisation for particular
algorithms and we have taken advantage of that, as we like to
work some of our orders in very specific ways.

I think that comfort level will only increase now that we have a
technology platform that allows us to quickly plug in and try new
algorithms. Our traders are already starting to suggest
customisation and tweaks to our providers.

As your comfort levels have risen, has your ratio of principal to
self executed trades changed?

It is changing, and I would say that the overall proportion of
trades we do using risk is reducing, although this is probably
because risk has become more expensive due to the recent market
volatility. As the tools for managing execution risk have become
more effective, and we have become more familiar with these
tools, we feel more comfortable with assuming execution risk.
This means that it becomes much more apparent how the trading
desk is adding value to the execution process. Of course it's not
as if we used to give trades to brokers and just say "work that
as best you can", but now we are able to explain in detail to
managers why and how we used a particular algorithm for their
order in order to achieve their execution objectives. Having said
that, we have a wide range of available methods of execution, and
each trade needs to be assessed according to its own
characteristics - if risk were to suddenly revert to the cheap
levels that were around last year, it would be difficult to
justify not using it.

What is your policy on research and commission sharing
agreements?

For Index funds, we have always paid for an execution only
service, but for Active funds, we are now unbundled in most
markets. We unbundled in the UK in 2006 and have also recently
unbundled in Japan, the US and Australia. Although too early to
say in these latter markets, from the dealing desk's point of
view unbundling in the UK and Europe has worked extremely well,
as it has completely disassociated payment for research from the
actual execution process. We have to be able to demonstrate why
we executed a trade in a particular way and it is a great relief
not to have the added complication of considering how a
particular broker actually fared in terms of research.

As regards commission sharing agreements, we decided quite early
on that we wanted to sign these with all of our brokers, so any
broker on our list will have one in place. Although this provided
an initial administrative burden, the approach has worked well,
and has occasionally created some slightly surprising outcomes,
such as a small UK agency only broker having to pay some money at
the end of the quarter back to one of the bigger houses.

"…algorithms now offer the user far more configuration
flexibility than in the past…"

What do you regard as the main differentiators for
broker-provided tools?

Performance, obviously, but also ease of use and flexibility, as
you need tools that you can deploy easily when trading under
pressure. Service is very important to us - especially now we are
getting used to our new technology and need to push it further to
see what it can do for us. It requires a support team with people
willing to respond quickly and come in to see us at short notice
to resolve any issues. Another facet of that service quality in
our eyes is a broker's willingness to work with our technology
provider. Finally, there is the speed of response to structural
market change. For example, as new venues such as Turquoise come
online, we will expect providers to adapt their existing
algorithms in a timely manner so we can take advantage of all the
different available venues.

Do you think smaller brokers are being disintermediated by being
unable to offer their own tools and what would you feel about
them offering algorithms white labelled from another provider as
a means of preventing this?

I have been expecting to see quite a bit of consolidation among
smaller brokers. I think this process is underway but as yet it
doesn't seem to be as advanced as I anticipated.

We've certainly been approached regarding the white labelling of
algorithms, and I think there are a number of points to consider
in this respect. For brokers that have not traditionally been
leaders in the technology stakes, attempting to break into the
algorithmic space from scratch would require an extremely serious
investment. Therefore, commercially it makes sense from their
perspective, as it potentially allows them to 'close the gap' in
the services on offer to their clients. From a mutual standpoint,
it could also allow both the client and the offering broker
leverage from their existing relationship - so, conceptually,
there is no reason why a white labelled algorithm would be
problematic. However, there is obviously a need for security and
transparency, so at the very least one would need to know the
source of the algorithms. Therefore, while I certainly wouldn't
reject white labelled algorithms out of hand, I would definitely
want to ask some fairly searching questions about their
provenance.

Is there a risk that in attempting to offer the buyside trader
flexibility algorithms are becoming too ergonomically complex in
terms of the number of controls and options they have?

I would certainly agree that algorithms now offer the user far
more configuration flexibility than in the past, so I suppose
there is the potential for the workflow benefit of an algorithm
to be degraded through over-flexibility. However, I have to say
that we haven't found it a problem in practice. We are able to
save a generic default setting and adapt it to suit individual
circumstances, so it's not as if we have to set everything up
from scratch for each trade we do. Having said that, you always
have to make some tweaks because every order is different.

What is your policy on pre-trade analytics?

The integration of Portware will give us the ability to analyse
the differences between predicted and actual cost of trading in a
far more granular manner. However, the whole status of pre-trade
analytics has been thrown up into the air with the arrival of
MiFID and the various different trade reporting venues. Pre-trade
models largely rely on historic trade patterns, and I would
imagine the providers of such analytical models have a job on
their hands in identifying the true picture of these patterns,
due to the issues surrounding the publication of post trade data.

You mention MiFID; what is your perception of it so far?

I confess my feelings are slightly mixed. From my personal point
of view, the abolition of the stock exchange 'concentration
rule', thereby opening up the industry to competition and
actively encouraging rival trading platforms, can only be a good
thing. Ultimately, this should help to further drive down the
costs of trading, not least by closing spreads and minimising
market impact. However, I would say there is certainly some pain
being felt by both buy and sell sides, while the industry adjusts
to the changing landscape. As I mentioned previously, getting to
grips with the impact on post trade reporting is particularly
challenging, and while we've seen benefits in some countries,
where previously you had very limited visibility in terms of
execution data, the trade-off has been a much more clouded view
of the trades going through in the UK market. The UK market was
already pretty advanced in terms of clarity and transparency
prior to MiFID; we could actually see a clear picture of what was
going on and were content with that. Now, the fact that
participants can report their trades on various different venues
means that there is a great deal of uncertainty around trade
reporting. It is often unclear whether some trades are being
double counted, triple counted, or even printed at all. I'm
pleased to see that the FSA has taken on board some of these
concerns, and seem keen to ensure the equilibrium is restored.
Hopefully we will hear some news on that subject before too long.

How do you handle transaction cost analysis?

We have a methodical approach to post-trade transaction cost
analysis, which takes place on several different levels.

On an individual trade level, all orders are analysed to compare
results against the benchmark and the expected outcome. Any
discrepancies with the expected outcome are investigated and may
necessitate discussions with the broker.

If a particular algorithm doesn't perform as expected then we
will contact the provider and discuss the likely reason - whether
any parameters need changing, or whether an alternative algorithm
would have been more appropriate.

As well as this dynamic post trade analysis, dealers provide a
monthly overview of their trades, documenting their observations
and highlighting any standout trades.

Finally, to complement the in-house post trade analysis process,
we subscribe to the ITG Transaction Cost Analysis (TCA) service.
On a quarterly basis, we review ITG's TCA analysis on our
transactions to pick up on any trends or focus on specific areas
of the execution process.

At present, we are not analysing the performance of individual
algorithms through ITG. However, I think that will come in time
so that we will be able to make direct comparisons between the
same generic types of algorithm supplied by different brokers.

What is your view on the recent dark pools collaboration
announcement by Morgan Stanley, Goldman and UBS?

It is an exciting development, though of course it is only
happening in the US at the moment so you have to hope that
something similar will happen in Europe too. Some rivals have
attempted to talk down the significance of the announcement and
claimed that the signatories to the agreement will put orders
through their own book first before putting them in the dark
pool. But coming to this agreement itself is exciting for the
industry going forward. I certainly hope that the initiative will
gather momentum, because while everybody keeps talking about the
virtues of dark pools, you can still only access them
individually which is extremely time-consuming.

How do you handle portfolio transitions?

Portfolio Transitions are managed by the transition team, but the
execution of trades is handled by the dealing desk, alongside
business as usual. At the start of each transition, there is a
lot of discussion between the transition manager, the dedicated
fund manager, and the dealing desk. Every angle is discussed, and
it is critical that all are on the same wavelength, to ensure the
transition is as successful as possible. As you would expect,
from the volume of trading that goes through our desk, the
opportunities for internal crossing are very significant. We
don't have any set methodology about the manner in which we trade
transitions; we may use principal trades but equally we could use
algorithms. From my point of view, it's a case of having
everything in your trading toolkit available - the aim is, as
always, to minimise total transaction costs.

How do you categorise trades into high, mid and low touch?

At present, the individual trader makes a judgement call based on
the fund manager's requirements. However, we intend to introduce
a systematic process for categorising trades. There are obvious
advantages to doing this automatically so that low touch trades
can be immediately identified and dealt with, leaving the trader
free to focus on the more demanding orders.

Finally what do you see as the main priorities for an effective
buyside trading desk?

I would say that these days versatility comes fairly near the top
of the list; you need a team of traders capable of turning their
hands to multiple markets as required, but also capable of
assimilating new technology and working practices quickly. I am
extremely proud of my team. Since I joined the desk here in 2000,
the industry has changed radically and looks likely to continue
to evolve at a similar pace in the near future. In an environment
like this, flexibility is obviously a priority, as is the ability
to work effectively and be capable of processing a wide range of
trading requirements, often under pressure.